The Bank of Canada’s policy decisions influence interest rates throughout the Canadian economy for businesses and consumers, lenders and borrowers. Yesterday, the Bank released a discussion paper by Rhys Mendes, written for Canadian monetary policy wonks. This paper explains the Bank’s current thinking behind the ”œneutral” level for its key policy interest rate.

As Luke Kawa (editor at Business in Canada) observed, yesterday’s speech by the Bank was a big one because it more formally moved the Bank from a lower-for-longer stance on rates to lower-for-the-long-run. This may be good news if you’re borrowing longer-term for a house or a car, but may be depressing news if you’re looking to make a good return on your longer-term retirement savings.

This is because the Bank estimates that Canada’s ”œnew neutral” policy rate is now around 3-4% in nominal terms, down significantly from roughly 5% a decade earlier.

The idea that our neutral rate had fallen has been understood for some time by Canadian monetary policy experts (including Chris Ragan of McGill); the big contribution of the Bank’s paper is to quantify and publicly present its new estimate.

The paper identifies three longer-term structural forces that have lowered Canada’s neutral rate:

1) lower potential output growth in Canada (due to population aging, which is slowing labour force growth);

2) higher global savings (from central banks in emerging markets looking to build precautionary buffers, to oil-exporting countries that are benefiting from higher energy prices that allow them to accumulate foreign assets); and

3) higher credit spreads (associated with increased demand for assets that carry less risk, which could be partly related to financial reforms that require stronger capital requirements).

Canadian interest rates, therefore, depend on various developments that affect savings and investment in both domestic and foreign markets. Indeed, one noteworthy, if not surprising, result in Table 4 of the paper is the empirical evidence that suggests foreign factors may matter more than domestic ones for Canada’s neutral rate. The Bank’s results underscore just how crucial US monetary policy, as set by the Federal Reserve, is for borrowing costs in Canada.

What does the new neutral rate mean for the conduct of Canadian monetary policy?

The neutral rate is a simple tool to gauge the Bank’s policy stance. Right now, when the policy rate (of 1%) is below neutral (3-4%), the Bank is providing monetary stimulus to nudge the economy along; alternatively, when the rate is above neutral, the Bank is trying to slow the economy.

A subtler point is that in the current context of economic « headwinds » abroad ”” like deleveraging households in the US, fiscal consolidation in Europe and heightened global uncertainty ”” the Bank’s policy rate could remain below this lower neutral rate (say less than 3.5%) even after inflation is at its 2% target and the Canadian economy is judged to be operating at its potential. In a breezy environment with foreign headwinds slowing the Canadian economy, offsetting economic stimulus is needed simply to keep Canadian output growing at its potential.

Canadian rates may not be going up soon, and when they do ultimately rise they’ll be aimed at a lower long-run neutral target rate ”” and below neutral if negative international factors warrant. In other words, don’t be surprised if the « new normal » based on the « new neutral » entails a « lower-for-the-long-run » stance for our monetary policy.

Stephen Tapp
Stephen Tapp était directeur de recherche à  l'IRPP, où il a dirigé une initiative de recherche sur les échanges commerciaux, dont les travaux seront publiés dans un ouvrage intitulé Redesigning Canadian Trade Policies for New Global Realities. Auparavant, il était économiste principal auprès du directeur parlementaire du budget du Canada. Il a travaillé à la Banque du Canada et à Finances Canada dans le secteur de la recherche ; il a été chercheur à l'Institut C. D. Howe et chargé de cours en science économique à l'Université Queens. Twitter : @stephen_tapp.

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